I believe in the concept of capital preservation first, then capital growth second. I also believe that liquidity is very valuable, financially and emotionally. Text book financial theory will tell you that cash is a drag on returns in your portfolio. The argument is, over time, stocks, bond, real estate, etc should appreciate at a higher rate, therefore, being fully invested at all times is the prudent decision. That reminds me of the old saying, “In theory, there is no difference between theory and practice. But, in practice, there is.” Investments go up until they don’t. National real estates could never drop until they did. Cash will always underperform is a rising market, but cash is a great place to be in down markets. Holding cash can also allow you to act when prices drop while others are suffering large losses. Most importantly, cash gives you the freedom to handle a job loss, a reduction in pay, an illness, etc.

When people start talking about investing cash savings, it really shows how short memories are. The S&P 500 declined over 60% from peak to trough between 2007-2009. While the market has recovered and gone on to new all-time highs, how many people sold around the trough and suffered the losses, without all the subsequent recovery?

If you need the money in the next few years or are over 50, then the value of cash can’t be overstated. You don’t have time to recover from a large loss in the stock or real estate market. The best way to accumulate wealth over time is to 1) do everything you can to maximize income, 2) spend 10-20% less than your take-home pay and 3) take a prudent, long-term view of investing. In my mind, #3 includes holding a sizable cash position to provide financial flexibility and peace of mind.

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Here’s how I put together my own plan:

1. Get a clear picture of where you currently stand. This will include your retirement accounts, non-retirement investments, bank accounts, house and any other assets. This is called your Net Worth. Here’s a post I did previously on calculating your Net Worth.

2. Analyze your income and savings patterns. How much are you saving every year in absolute dollars and as a percentage of your total income. Most people recommend saving 10-20% of your income. This would be your total savings – retirement contributions, other investments and cash savings. I always include employer contributions into the equation. If your employer is putting 5% of your income, count that towards your savings plan. Ideally that will only serve to increase your total savings, but either way, that is actual money being contributed to your savings plan.

3. Determine how you want to save. I am a believer is using tax-advantaged accounts such as 401k and IRAs, but I also believe in the value of after-tax, easily accessible savings. Read this for more on non-retirement investments.

4. Use a relatively simply Excel model to make projections. Here is a spreadsheet I created for two accounts, but you can easily adjust to your situation (Retirement Projections). An even easier way would be to group all your tax-advantaged accounts into one group and all your taxable investments into the other – then make your projections like that.

5. After you complete Step 4 you are able to see if you need/want to make changes to your savings plan to accomplish your goals. I think it’s safe to withdraw 3-6% a year from your accounts when you’re in retirement, so look at your future balance and determine if that amount will be sufficient for you. Inflation is always a concern, but overtime investments should keep up with inflation. I use lower returns, to capture the annualized real return, meaning, the return over inflation in a given year. Using return figures in the 3-8% annually I think is fair. This is allow you to look at the future balance and future annual income in approximately today’s terms.

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First, investing in municipal bonds carries real risk. People are lead to believe that muni bonds carry similar risk to US Treasuries, but recent history suggests that is not true. Bankruptcies in Detroit, various California cities, Jefferson County, Alabama, etc have shown that muni investors often get pennies on the dollar when a bankruptcy is filed. While it is true that some muni bonds are insured against a loss, many are not. If you are invested in munis, or considering investing in munis, make sure you are buying insured bonds or be prepared for much higher levels of risk than the yield would imply. Even with insurance, you are counting on the credit quality and financial capability of the insurer to make you whole. We saw several bond insurers on the verge of collapse during the 2008/2009 credit collapse, so their solvency is not guaranteed.

Second, as a citizen and a taxpayer, you need to start paying more attention to your state/city finances. Large pension contributions are beginning to eat up significant chucks of municipal operating budgets. What this means is either services have to be cut, government worker and retiree benefits have to be cut or taxes have to be raised. No one wants to see police/fire services reduced and government employee unions aggressively fight to prevent pension cuts. That means, raising taxes is often the first, and easiest measure. In essence, many governments are deciding that hard working, middle class Americans need to pay more in property, income or sales tax to keep funding generous pensions fore retirees. As a citizen you need to be informed about what is happening with the finances of your locality.

This problem is likely to get a lot worse before it gets better. Promises were made to employees by politicians that had no hope of being kept. In many cases, the politicians didn’t care, assuming they would be out of office before the problems arose. The time has arrived though, or is beginning to arrive around the country. As an individual working to secure your own retirement, this issue needs to remain on your radar.

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